A key part of financial planning is estimating what investors can expect to earn on their portfolios over the next 10, 20 or even 30 years. You can retire in 10 years with $50,000 a year "assuming an average annual return of 6 per cent a year," a planner might say.
Where can a person get that rate in this market, readers might wonder. The planner's forecast may be 5 per cent, or 6 or even 7. The higher it is, the more perplexing people find it, and with good reason. Yields on bonds and guaranteed investment certificates are at historic lows. The next move in interest rates could well be up, which would hurt bond prices.
So where will the money come from? Mainly from stocks, and the dividends they pay, advisers say.
"In today's environment, everybody is being forced to invest in the stock market if they want to grow their wealth," says Allan Small, an investment adviser at HollisWealth in Toronto.
Other advisers agree. "For the foreseeable future, you won't get 5 or 6 per cent without taking some stock market risk," says Adam Weinstock, a portfolio manager at ScotiaMcLeod in Montreal. "The key message would be making sure clients understand how asset mix flows through into returns," Mr. Weinstock says.
Looking back at history
Investment advisers and planners start by looking at historical returns. Over the past 25 years, for example, stocks and bonds have done well on average. In the future, though, bonds could be a bit of a drag, at least for a while.
"What history has shown is probably not a reasonable guide going forward," says Eric Davis, an investment adviser at TD Waterhouse in Kamloops. As a result, many advisers and planners have scaled down their assumptions. Mr. Davis targets 4 per cent to 6 per cent a year for future returns, including 2 per cent inflation.
This is how the numbers break down: Cash and cash equivalents yield 2 per cent; bonds and other fixed income 3 per cent; and stocks 7 per cent. With these assumptions, a balanced portfolio with 50-per-cent fixed income and 50 per cent equity would return 5 per cent a year.
This is in line with the updated assumptions prepared by the Financial Planning Standards Council last April.
Magic of compound returns
People who wonder where the numbers come from may be overlooking the power of reinvested dividends and interest, industry professionals say.
"Many do-it-yourself investors don't know the difference between yield and total return," says Jason Pereira, a financial planner at Woodgate Financial/IPC in Toronto. In their forecasts, advisers and planners use total returns, including reinvested interest and dividends.
It makes a big difference. To illustrate, consider the effect of reinvested dividends in three markets – the S&P/TSX composite, the Standard & Poor's 500 and the MSCI EAFE (Europe, Australasia and Far East) index. Over the past 25 years, stock prices alone in the three markets have risen by 5.82 per cent a year on average, says Matthew Ardrey, vice-president and financial planner at T.E. Wealth in Toronto.
That number rises to 8.32 per cent when reinvested dividends are included, a difference of 2.5 percentage points or more than 40 per cent.
"Let's say fixed income could have done 2 per cent a year over the same time period," Mr. Ardrey says. A balanced portfolio of 40 per cent fixed income (and 60 per cent stocks) would have returned 5.79 per cent. In his projections, Mr. Ardrey uses a 5-per-cent return, including 2 per cent inflation.
Mr. Davis of TD Waterhouse points to shares of Royal Bank of Canada, which are yielding about 4.2 per cent – more than half of his 7-per-cent target for stocks. The dividend has increased steadily over the years, by slightly more than 9 per cent a year.
That 4.2-per-cent dividend could be worth 6 or 7 per cent a few years from now to investors who bought the stock today. "And I'm willing to bet the share price will be higher in future," Mr. Davis says.
Bumps on the road
The returns that planners forecast are averaged out over the forecast period. The targets may range from 5 per cent to 7 per cent, but this year could fall short.
"This year, our balanced portfolio is coming in around 4.8 per cent," says Marc Henein, an investment adviser at ScotiaMcLeod in Mississauga. Markets could pick up later in the year.
"Some years you won't make it," Mr. Davis says. Mr. Ardrey agrees: "Some years you'll make 10 per cent, some years zero. It averages out at 5 per cent."
Despite the ups and downs, over time, a balanced portfolio delivers "a very steady rate of return," Mr. Henein says. The trick is staying the course. Where investors fall short is reacting emotionally to the market's ups and downs, he adds; for example, selling when the market turned down in late August.
"The magic of how we make money is simply by not trying to time the market," Mr. Henein says. "When you try to time the market, you get punished."
Asset allocation is key
This information prepared by Vanguard Group Inc. illustrates how asset mix affects returns. It shows the best, worst and average returns for various stock and bond allocations from 1926 to 2013.
Balanced portfolio of 50/50 stocks and bonds:
- Best return: 32.3 per cent
- Worst return: -22.5 per cent
- Average: 8.3 per cent
- Best return: 32.6 per cent
- Worst return: -8.1 per cent
- Average: 5.5 per cent
- Best return: 54.2 per cent
- Worst return: -43.1 per cent
- Average: 10.2 per cent